Commercial banks
A commercial bank may legally take deposits for checking and savings accounts from consumers. The federal government provides insurance guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC), on amounts up to $100,000. To get FDIC guarantees, commercial banks must follow a myriad of regulations, including the limitation that they cannot sell stock (or equity, as it is also called). Investment banks cannot take deposits and therefore are not subject to banking laws.
The typical commercial banking process is fairly straightforward. You deposit money into your bank, and they loan that money to consumers and companies in need of capital (cash). You borrow to buy a house, finance a car, or finance an addition to your home. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks can range in size from the dry cleaner on the corner to a multinational conglomerate.
Private contracts
Importantly, Loans from commercial banks are structured as private legally binding contracts between two parties - the bank and you (or the bank and a company). Banks work with their clients to individually determine the terms of the loans, including the time to maturity and the interest rate charged. Your individual credit history (or credit risk profile) determines the amount you can borrow and how much interest you are charged. Perhaps you need to borrow $200,000 over 15 years to finance the purchase of your home, or maybe you need $30,000 over five years to finance the purchase of a car. Maybe for the first loan, you and the bank will agree that you pay an interest rate of 7.5 percent; perhaps for the car loan, the interest rate will be 11 percent. The same process applies to loans to companies as well - the rates are determined through a negotiation between the bank and the company.
Let's take a minute to understand how a bank makes its money. On most loans, commercial banks in the U.S. earn interest anywhere from 5 to 14 percent. You probably earn a paltry 1 percent on a checking account, if anything, and maybe 2 to 3 percent on a savings account! Commercial banks thus make gobs of money, taking advantage of the large spread between their cost of funds (1 percent, for example) and their return on funds loaned (ranging from 5 to 14 percent).
Investment banks
An investment bank operates differently. I-banks are legally restricted from taking deposits by the Glass-Steagall Act. An I-bank, then, does not have an "inventory" of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary, and matches sellers of stocks and bonds with buyers of stocks and bonds.
Note, however, that companies use investment banks toward the same end as they use commercial banks. If a company needs capital, it may get a loan from a bank, or it may ask an investment bank to sell equity or debt (stocks or bonds). Because commercial banks already have funds available from their depositors and an investment bank does not, an I-bank must spend considerable time finding investors in order to obtain capital for its client.
Public securities
Investment banks typically sell public securities (as opposed to commercial banks, which, we should remember, enter into private loan agreements). Technically, securities such as Microsoft stock or Ford AAA bonds, represent government-approved stocks or bonds that are traded either on a public exchange or through an approved dealer. The dealer is the investment bank.
Let's look at an example to illustrate the difference between private debt and bonds. Suppose Acme Company needs capital, and estimates its need to be $200 million. (Acme is bigger than your corner dry cleaner.) Acme could obtain a commercial bank loan from Citibank for the entire $200 million, and pay interest on that loan just like you would pay on a $2,000 loan from Citibank. Alternately, it could sell bonds publicly using an investment bank such as Merrill Lynch. The $200 million bond issue raised by Merrill would be broken into many bonds and then sold to the public. (For example, the issue could be broken into 200,000 bonds, each one worth $1,000.) Once sold, the company receives its $200 million and investors receive bonds worth a total of the same amount.
Over time, the investors in the bond offering receive coupon payments (the interest), and ultimately the principal (the original $1,000) at the end of the life of the loan, when Acme Corp buys back the bonds (retires the bonds). Thus, we see that in a bond offering, while the money is still loaned to Acme, it is actually loaned by numerous investors, rather than a commercial bank.
Because the investment bank involved in the offering does not own the bonds but merely "placed" them with investors at the outset, it earns no interest - the bondholders earn this interest in the form of regular coupon payments. The investment bank makes money by charging the client (in this case, Acme) a small percentage of the transaction upon its completion. Investment banks call this upfront fee the "underwriting discount." In contrast, a commercial bank making a loan actually receives the interest and simultaneously "owns" the debt.
Later, we will cover the steps involved in underwriting a public bond deal. Legally, bonds must first be approved by the SEC, the Securities Exchange Commission. (The SEC is a government entity that regulates the sale of all public securities.) The investment bankers carefully guide the company through the SEC approval process, and then market the offering utilizing a written prospectus, its sales-force and a "road-show" to find investors.
The Question of Equity
Investment banks underwrite stock offerings just as they do bond offerings. In the stock offering process, companies sell a portion of the equity (or ownership) of itself to the investing public. Often, this offering of equity is through a process called an initial public offering of stock (commonly known as an IPO). Through the IPO process, stock in a company is created and sold to the public. After the deal, stock sold in the U.S. is either traded on the New York Stock Exchange (NYSE) or the newly merged entity, the Nasdaq/AMEX.
The equity underwriting process is another major way in which investment banks differ from commercial banks. Which I-banks may legally underwrite equity; a commercial bank may not, and miss out on the enormously profitable equity underwriting business.
But remember that commercial banks may legally underwrite debt, and some of the largest commercial banks have developed substantial expertise in underwriting public bond deals. So, not only do these banks make loans utilizing their deposits, they also underwrite bonds through a corporate finance department. When it comes to underwriting bond offerings, commercial banks compete for this business directly with investment banks. However, only the biggest tier of commercial banks is able to do so, mostly because the size of most public bond issues is large and Wall Street competition for such deals is quite fierce. Unless the Glass-Steagall Act is completely repealed, commercial banks will stick with their bread and butter-debt, as opposed to equity.
The Buy-Side Vs. The Sell-Side
The traditional investment banking world is considered the "sell-side" of the securities industry. Why? I-banking firms like Morgan Stanley Dean Witter, Merrill Lynch, and Goldman Sachs create stocks and bonds, and sell these to investors. "Sell" is the key word, as I-banks continually sell their firms' capabilities to generate corporate finance business, and salespeople sell securities to generate commission revenue.
Who are the buyers of public stocks and bonds? They are individual investors (you and me) and institutional investors, firms like Fidelity and Vanguard. The universe of institutional investors is appropriately called the "buy-side" of the securities industry.
Fidelity, T. Rowe Price, Janus and other mutual fund companies all represent a portion of the buy-side business. These are mutual fund money managers. Insurance companies like Prudential, Northwestern Mutual, and All State also manage large blocks of assets and are another segment of the buy-side. Yet another class of buy-side firms manage pension fund assets - frequently, a company's pension assets (built up through years of employee contributions) will be given to a specialty buy-side firm that can better manage the funds and hopefully generate higher returns than the company itself could have. There is substantial overlap among these money managers - some, such as Putnam and T.
Rowe, manage both mutual funds for individuals as well as pension fund assets of large corporations.
As we will discuss in more detail later, the financial services industry is changing rapidly, and the boundaries between the buy-side, the sell-side, and commercial and investment banking are deteriorating. Before we discuss those trends, however, we will cover the basics of the equity and the bond markets in the next chapter.
Hedge funds are the sexy side of the buy-side. Their popularity has grown tremendously over the past several year: With the bull markets still roaring, most hedge funds have performed extraordinarily well, with eye-popping returns of greater than 40 percent annually in some instances.
Hedge funds pool together money from large investors (usually wealthy individuals) with the goal of making outsized gains. Historically, hedge funds bought individual stocks, and "shorted" (or borrowed against) the S&P 500 or another market index, as a "hedge" against the stock. As long as the individual stocks outperformed the S&P, the fund made money.
Nowadays, hedge funds have evolved into a myriad of high-risk money managers who essentially borrow money to invest in a multitude of stocks, bonds and derivative instruments (these funds with borrowed money are said to be "leveraged"). If this sounds confusing, don't worry: The vast majority of investors do not understand the workings of a hedge fund. Just understand that hedge funds use their equity base to borrow substantially more capital, and therefore "multiply" their returns through this risky leveraging. Buying derivatives is a common way to automatically "leverage" a portfolio.
